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Contribution as a decision-making technique

Edexcel IAL Business · WBS13 Business decisions and strategy

Contribution (met in Unit 2 for break-even) is also a powerful decision tool. Because fixed costs must be paid whatever is decided, the question for many short-term decisions is: does this add to contribution?

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Nature and purpose

Contribution per unit = selling price - variable cost per unit. It is the amount each unit sold contributes, first towards fixed costs and then to profit.

Total contribution = contribution per unit x units sold (or total revenue - total variable costs).

Profit = total contribution - fixed costs.

Example: price $40, variable cost $25: contribution $15 per unit. Selling 6,000 units gives $90,000; with fixed costs of $60,000, profit = $30,000.

Special orders

A customer offers to buy extra units at a price below the usual price. If the business has spare capacity, fixed costs do not change, so the order adds to profit as long as price > variable cost per unit.

Example: an order for 1,000 units at $30 when variable cost is $25 adds (30 - 25) x 1,000 = $5,000 to profit.

Cautions: regular customers may demand the same low price; the order may use capacity needed for full-price sales; it may harm a premium brand.

Keeping or dropping a product

When fixed costs are shared out between products, a product can show a 'loss' even though it makes a positive contribution. Dropping it would remove its contribution but not the fixed costs, which would then fall on other products, so overall profit would fall.

Product	Revenue ($)	Variable costs ($)	Contribution ($)	Allocated fixed costs ($)	Profit ($)
X	120,000	70,000	50,000	30,000	20,000
Y	80,000	50,000	30,000	20,000	10,000
Z	50,000	38,000	12,000	20,000	-8,000

Z shows a loss of $8,000, but contributes $12,000 to fixed costs. Dropping it would cut total profit by $12,000 unless the fixed costs could also be cut.

Limitations

Assumes variable cost per unit and price are constant, and that fixed costs really are fixed.
Ignores qualitative factors: brand image, customer relationships, staff, the product's role in the range (for example a loss leader).
Short-term focus: in the long run all costs must be covered.

Worked example

A firm with spare capacity sells a product at $40 with variable cost $25. A new customer offers $30 each for 1,000 units. Should it accept?

Contribution per unit on the order = 30 - 25 = $5.
Total extra contribution = 5 x 1,000 = $5,000; fixed costs are unchanged because there is spare capacity.
Financially, accept: profit rises by this amount.
But consider whether regular customers will learn of the lower price, and whether the capacity might be needed for full-price orders.

Answer: Accept on financial grounds (+$5,000), subject to the effect on regular customers.

Key idea: Contribution = price - variable cost per unit; profit = total contribution - fixed costs. Accept a special order if price > variable cost and there is spare capacity. Keep a product with positive contribution unless its fixed costs can be cut.

Check yourself

A product sells for $18 and has a variable cost of $11 per unit. Calculate the contribution per unit.
Show answer
$7. 18 - 11 = $7.
Price $40, variable cost $25 per unit, sales 6,000 units. Calculate total contribution.
Show answer
$90000. (40 - 25) x 6,000 = $90,000.
Total contribution is $90,000 and fixed costs are $60,000. Calculate profit.
Show answer
$30000. 90,000 - 60,000 = $30,000.
A firm with spare capacity has a variable cost of $25 per unit. It is offered $30 per unit for 1,000 units. By how much would profit change if it accepts?
Show answer
$5000. (30 - 25) x 1,000 = $5,000.
Product Z has revenue $50,000, variable costs $38,000 and allocated fixed costs $20,000. If Z is dropped and fixed costs are unchanged, by how much does the firm's total profit fall?
Show answer
$12000. The firm loses Z's contribution: 50,000 - 38,000 = $12,000. The fixed costs remain.
A firm has spare capacity. When will a one-off special order at a low price increase profit?
- When the price is higher than the variable cost per unit
- When the price is higher than the full cost per unit
- Only when the price is higher than the usual selling price
- When fixed costs are zero
Show answer
When the price is higher than the variable cost per unit. Fixed costs are already covered, so any positive contribution adds to profit.
Which is a qualitative reason to reject a profitable special order?
- The order has a positive contribution
- The firm has spare capacity
- Regular customers may demand the same lower price
- Variable costs are below the price
Show answer
Regular customers may demand the same lower price. It could damage relationships and future pricing.
Explain why a business might keep a product that shows a loss after fixed costs are allocated.
Show answer
The product still makes a positive contribution towards fixed costs, which would not disappear if it were dropped, so dropping it would reduce the firm's total profit.. Contribution, fixed costs, effect on total profit.

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Sources

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (XBS11/YBS11, 2018), Unit 3 Business decisions and strategy and Appendices 6, 7 and 9

Last updated 8 November 2026. Spotted a mistake? Tell us.